Tired of Feeling the Squeeze?
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It’s tough enough for plan sponsors to deal with eroding pension assets and a sluggish economy. Adding insult to injury is an obsolete, punitive and internally contradictory regulatory overlay that makes it harder for sponsors to navigate the economic storm they face. It is essential, therefore, for sponsors to raise their voices today to get some relief, or face near-certain drowning.
In particular, Federal minimum funding rules and accounting requirements are creating an artificial financial crisis that will make the funds’ true losses appear far worse than they are. The result could be a downward spiral for the entire U.S. economy.
In recent months, many major companies have disclosed that investment losses on their pension funds are having a major impact on their reported 2002 earnings, and this is based on 2001 investment results. The continuation of the bear market in 2002 means more scary news in the year ahead.
Ford, for example, recently reported it just had to contribute $500 million to its defined benefit pension plan to offset a shortfall, and would kick in another $500 million by June. Ford said its decision to cut its assumed rate of return on pensions in the U.S., Canada and Britain to 8.75% from 9.5% would trigger an estimated $270 million pretax cost this year. And lower-than-projected returns for GM’s fund, meanwhile, forced the auto giant to make a $2.2 billion contribution last year after having made no contributions in the previous two years. More recently US Airways is seeking relief from the federal agencies (PBGC) on minimum funding rules for its pension plan to help it emerge from bankruptcy. Without that relief the plan may have to terminate and thousands of workers would lose significant benefits.
While the dollars are large in those examples, the story’s the same throughout the pension landscape. Such disclosures serve to fuel a continued lack of confidence in the economy, depressing stock prices and creating more bad news in 2004 as well.
Collective bargaining disasters
And that’s not all: In the collective bargaining arena, both labor and management are facing financial disasters with the implications of the federal funding and various liability rules on their pension funds. One fund we are working with illustrates the point: The plan is 100% funded for all benefits earned to date, and 88% funded for all benefits ever to be earned and paid in the future. Yet this fund is facing a funding requirement that will force the employers to more than double the amount they contribute in the near future.
Public sector funds, while hardly immune from investment losses, are thankfully, in better shape in terms of disclosure requirements. (Lurking in the background, however, is the prospect of new GASB-mandated accounting requirements.) As a result, public sector pension funds can rely on the experience and judgment of their actuaries in riding out this economic storm.
Here’s a closer look at some of the anomalies and absurdities of Federal pension funding and accounting rules that are creating no-win situations for plan sponsors and, ultimately, participants, beginning with minimum funding rules.
Funding Rule Flaws
The better a pension plan is funded, the greater the cost to fund an investment loss, when compared to a less funded plan that earns the same return. Suppose, for example, a fund with $10 million in assets and $10 million in liabilities suffers a 10% investment loss (i.e. the plan was fully funded). The sponsor must make up $1 million. But if instead the same plan was under-funded and only had $5 million in assets, it would only face the short-term need to recoup a $500,000 loss. Bottom line: Better funded plans have more money at risk. Given their greater funding security, why penalize them more?
Plan assets that are lost (due to declining investment values) and held but won’t be paid to plan beneficiaries for 20 or more years, must, under IRS rules, be fully amortized many years before benefits must be paid (e.g. US Airways). Specifically, such losses when incurred by corporate plans must be amortized over five years, and over 15 years for Taft-Hartley plans.
In corporate and collectively bargained plans, tax-deductible contribution limits often force funds either to stop making fund contributions (thereby putting the funds invested at greater risk in the event of a subsequent market decline), or raise benefit payments when investment results are strong.
When a plan hits the IRS funding ceiling, the sponsor, of course, can no longer deduct the contributions from its taxable income. However, in the collective bargaining situation, the sponsor is still required to make the contributions to the fund under its collective bargaining contract, since contracts are simply based on a fixed regular contribution to the fund independent of tax considerations. What is typically done to rectify this situation is that the actuary calculates how much benefits must be increased in order to soak up the contribution and make it deductible to the sponsor. If the money went in anyway (which it must) and was not deductible, the sponsor is subject to penalties until such a time as the contribution becomes deductible.
Narrow funding standards effectively impose severe limits on a fund’s ability to pre-fund future liabilities to cover the risk of future investment downturns. Similarly, the IRS focuses on severely limiting plan sponsors from paying more when they can most afford it, and the PBGC focuses on making plan sponsors pay as much as possible when they can least afford it. The conflicting interests of these two independent Federal agencies leaves plan sponsors between a rock and a hard place.
Accounting rule challenges
As if problems with funding rules weren’t bad enough, here’s a quick rundown on what plan sponsors are up against with accounting standards:
- When a pension’s portfolio is performing beyond expectations, funding obligations are reduced or eliminated, with a positive impact on the corporation’s bottom line. Result: During bull markets profitability is exaggerated. But the flip side is also true: During bear markets, such as the present, a corporate plan sponsor’s P & L is rendered artificially bleak due to accounting charges related to pension funding obligations.
- Since pension fund asset earnings ultimately are for the benefit of plan participants, not corporate shareholders, one might reasonably ask why accounting rules must dictate that reported corporate earnings must gyrate wildly based on the short-term performance of the company’s pension assets. These pension assets are intended to cover long term obligations.
- Required liability disclosures under accounting rules also affect the corporate bottom line. But the discount rates used to measure those liabilities are automatically higher during bull markets, thus exaggerating the amount of the liability reduction, and the reverse is true during bear markets.
- History shows that good returns follow bad returns eventually, and vice versa. Yet accounting rules effectively force sponsors to project future returns based on relatively recent experience. A more logical approach would be the reverse: As a bull market cycle progresses, the discount rate should decrease to anticipate the inevitable bear market; and as a bear market is running its course, the discount rate should be allowed to increase.
- Since pension plans represent a sponsor’s long-term commitment to its employees, why can’t the accounting profession accept the advice and analytical work of those technical experts best equipped to quantify the long-term financial obligations and liabilities of pensions — i.e. actuaries — who know best how to safely dampen the impact of market fluctuation?
Rigid amortization schedules
And here’s a significant problem involving both federal pension funding and accounting rules: Both consider that a dollar paid today has the same value as a dollar paid 15 years from now.
The best way to understand the concept is to think about a home mortgage. When you buy your first house you’re probably stretching the budget and worrying about how you are going to make those high monthly payments. But after a few years, the burden and anxiety is diminished, thanks the fact that you (typically) are earning more relative to the fixed monthly obligation. Yet the IRS’ liability amortization schedules don’t allow sponsors to take advantage of the predictable easing of the funding burden.
Public sector funds, however, are permitted to amortize payments with obligations rising in the future to reflect the impact of inflation, rather than using a level funding schedule. For example, you may contribute $100,000 this year but $150,000 in ten years’ time to reflect anticipated inflation of 4% per year.
This practical and more realistic approach recognizes that a dollar today is not the same as a dollar 10 years from now. It also means that the “burden” of the amortization payment remains the same as a percentage of payroll, and so the contribution to the plan when expressed as a rate will stay more stable.
Here’s a quick rundown on what can—and should—be changed.
- Pension funds should be allowed to build a fund surplus of at least 25% of the liabilities, before federal maximum deductible limits take effect. (Currently funds cannot continue to set aside rainy day funds once a plan is deemed fully funded.)
- Liabilities should be allocated to the years they will ultimately be paid out, and then the amortization of any gains or losses on such assets should have an amortization period related to that period. So for example, if 20% of the fund liabilities are not to be paid out until say, 30 years from now, then 20% of the investment loss (assuming the fund was 100% funded before the loss in this example) should have at least a 30 year amortization period.
- Discount rates for accounting purposes and investment assumptions for federal funding rules should be lowered after a sustained bull market, and increased after a sustained bear market, or, at a minimum, they should remain fixed at a reasonable level throughout any type of market.
- Amortization payments for minimum funding and maximum funding should reflect inflation, and not be set in level dollar terms. Why limit this common sense approach to public sector plans?
- Conflicts of interest between the PBGC and the IRS need to be eliminated, and a single agency, just for pension funding purposes, should establish soundly designed funding rules that balance the requirements and needs, during bull and bear markets.
These recommendations, if adopted, would provide benefits for everyone. Here are our top ten:
- Plan participants will enjoy greater benefit security and less benefit fluctuations.
- Plan participants will face less loss of benefits through forced plan mergers or terminations.
- Plan sponsors will face significantly reduced volatility in their annual funding, expensing and disclosure amounts.
- Plan sponsors will face a reduced risk of bankruptcy.
- The PBGC exposure to plan terminations will decrease.
- The impact on the IRS’ revenue stream will be neutral, and the federal government annual tax dollars collected will be less volatile.
- The U.S. taxpayer will pay lower taxes long term, as the welfare social insurance costs of paying for the lost pension benefits under the current environment will decrease.
- The U.S. economy will improve, because during bull market cycles corporate stock prices will not be inflated due to the exaggerated corporate earnings resulting from greatly reduced funding requirements and accounting disclosures.
- The U.S. economy will be stabilized because during bear markets the corresponding and exaggerated increase in funding costs and accounting disclosures under the current rules will be greatly relaxed.
- In the end it’s smart, the right thing to do and everyone wins.
What you can do
None of these changes will occur without the plan sponsor and provider communities getting involved. The usual strategies—contacting Congressmen and Senators and industry representatives—are always vitally important.
But in addition, we urge you to join with us to build a multi-faceted coalition representing labor, management, professional, and taxpayers’ interests. To help us move forward with this effort, please drop us a line of support at join@Cheiron.us